The most complete evidence on the value for money of PPP-type approaches comes from the Private Finance Initiative (PFI), the UK government programme to increase the involvement of the private sector in the provision of public services. Introduced by the Conservative government in November 1992, it continued under Labour in 1997. As of July 2003, 451 PFI projects had completed construction and were in operation, including 34 hospitals, and 119 other health schemes, 239 new and refurbished schools, 23 new transport projects, 34 new fire and police stations, 13 new prisons and secure training centres, 12 waste and water projects, and 167 other projects in sectors such as defence, leisure, culture, housing and IT. The PFI scheme has been widely discussed and extensively examined, and two types of evidence are considered in this section. First, we report summaries of PPP–PSC value-for-money comparisons for individual projects. Second, we examine evidence of the rates of return on PFI projects.
Value-for-Money Tests
It is difficult to draw inferences from individual episodes. Inevitably in a market environment not all PPPs will go to plan, and there is a tendency in some quarters to treat every failure of a PPP as evidence that PPPs are funda- mentally flawed. A judgement as to whether a PPP has worked needs to be made against a realistic assessment of what can be achieved by public procure- ment, rather than some idealized conception of government performance.
After all, not every traditional procurement goes to plan, and government fail- ure is very real and cannot be overlooked. In order to evaluate whether PPPs have something to offer, it is important to look at available evidence as to the overall success or failure of the PFI vis-à-vis conventional procurement.
Earlier in Chapter 4 (see Table 4.3) we reported the evidence assembled by the UK Treasury and the NAO to the effect that the overwhelming majority of PFI projects were delivered on or ahead of time, and that almost all were within budget. This evidence contrasts sharply with an earlier survey of trad- itional government procurement of infrastructure, where projects were mostly over budget and over time. These results are also consistent with the Mott MacDonald (2002) survey, where ‘optimism bias’ seemed to be less for PFI projects than for other procurement methods.
There have also been independent assessments made of projects in terms of value-for-money tests. A review, commissioned by the Treasury Taskforce and published jointly by the London School of Economics and Arthur Andersen in January 2000, analysed 29 public sector projects that used the PFI and it was calculated that on average the predicted saving, compared with conventional
procurement, was 17 per cent (Arthur Andersen, 2000). In its own separate analysis, the National Audit Office has produced value-for-money reports on 15 projects, 7 of which (including a hospital project) were evaluated for value for money against a public sector comparator for traditional public procure- ment. Overall, the total cost savings of these projects was 20 per cent (NAO, 2001).
These estimates of projected savings are arrived at by comparing the cost of the PFI project with its public sector comparator, and thus refer to long-term projects that by definition are not yet complete – the actual outcomes will not be known for many years. In addition, Allen (2001) argues that such averages conceal considerable differences across PFI types, with road and prison projects achieving ‘reasonable efficiency gains’, while those for schools and hospitals show ‘minimal gains’ (p. 32). This difference is attributed to two factors. The first is that for road and prison projects, there is no partitioning of core and ancillary services, enabling the private contractor to make design and build innovations in the knowledge that they will also be responsible for oper- ating and maintenance services. In PFI health projects, core and ancillary services remain segmented, perhaps reducing some of the potential for innov- ation. The other reason is that for roads and prisons there is a single, central government agency handling the contracting, whereas with health and educa- tion private sponsors must deal with a number of bodies such as local educa- tion authorities and school governing councils.
There is another point that needs to be borne in mind with respect to health and schooling – both of these continue to be highly charged political areas in the UK. Health, in particular, is the sector about which critics of PFI have been most vocal (e.g. Mayston, 1999; Pollock et al., 1997; Pollock, 2000).
However, the dilemma that cannot be avoided is that public funding has not kept up with advances in medical technology, and this has led to a budgetary crisis in the system. In such an environment, if PFI can deliver genuine cost savings or efficiency gains then the experiment would seem worthwhile. Yet PFI cannot overcome the basic issue of ‘affordability’, which arises because the ‘Trust’s expectations exceed the realities of their budgets’ (Grimsey and Graham, 1997, p. 220).
Rates of Return Test
A very different test was undertaken by Pricewaterhouse Coopers (PwC) (2002), commissioned by the Office of Government Commerce. It analysed the projected rates of return on a sample of PFI projects to ascertain whether the returns that the private sector expected to earn for managing and bearing risk were excessive or in line with what might be anticipated from a competi- tive market among bidders. We noted earlier in this chapter that a high degree
of competition is needed in the bidding market for PPP/PFI to guarantee that the private sector entities will submit their most competitive bids and offer good value for money to government. The report takes as its starting point the fact that, with competition, project internal rates of return should reflect exactly the returns required by diversified investors, as indicated by the weighted average cost of capital.
In order to examine whether this is the case, a sample of 64 PFI projects was selected, covering a wide range of activities to which PFI has been applied, and representing about 23 per cent of all PFI projects in terms of construction value. As the measure of expected private sector return, the report uses the nominal post-tax internal rate of return as projected at financial close.
The project return is compared with the weighted average cost of capital, and is the return that should be expected from a project by a diversified investor, according to the project’s risk. It is derived from publicly available informa- tion for businesses with broadly comparable activities, principally in the regu- lated utility sector, using CAPM to derive the appropriate cost of equity, and adopting the cost of debt from the financial model for each project to produce a weighted average cost of capital. CAPM hypothesizes that equity investors demand a premium above the risk-free rate of interest to compensate them for the risk associated with the investment in hand, where the risk premium is a function of the systematic risk of the investment under consideration.
Across all projects in the sample, the internal rate of return is found to aver- age 7.7 per cent per annum. By comparison, the average weighted average cost of capital is estimated to be 5.3 per cent per annum. Thus the ‘spread’, the amount by which the average project internal rate of return is higher than the cost of capital, is 2.4 per cent per annum. This spread is described as an esti- mate of the total excess projected return on PFI projects above the cost of finance. Note that the equity returns and project returns are expected returns (ex ante). The projects will not necessarily earn this return over their lifetime project (ex post) because things might go better or worse than expected.
Indeed, while most projects have been successful, a number have led to investors losing money rather than making their expected returns.
Nevertheless, the PwC report contends that even if the projected returns are earned, only part of the spread represents excess returns to the investors, for two reasons. First, between 0.7 per cent and 1.3 per cent (average 1 per cent) may be accounted for by bid costs. The costs of bidding under PFI are higher than in other types of procurement. Overall projects bidders must be expected to recover all their costs – including those on unsuccessful bids – before making a return. For the projects in the sample, the costs incurred before a preferred bidder is announced average about £1 million. The average bidder succeeds in one bid out of three or four, yet the financial projections for indi- vidual projects that provide the basis of the PwC study only show the costs of
bidding for the particular project that has been won. Thus they do not explic- itly reflect costs of other unsuccessful bids, which have to be recovered at least in part through the equity return. Second, under the 25–30 year contracts of the PFI, bidders may price their target returns over a fixed rate such as the swap rate rather than the gilt rate, as assumed in the conventional CAPM. The use of swap rates rather than the gilt rate as the risk-free rate in the cost of equity would increase the average cost of capital from 5.3 per cent to between 5.75 per cent and 6.25 per cent.
Consequently, of the ‘spread’ of 2.4 per cent per annum, 1.7 per cent is thought to be accounted for by two factors:
• unrecovered bid costs on other projects (about 1 per cent);
• the higher cost of underlying rates for private sector borrowing compared with public sector borrowing, primarily caused by the cost of swaps compared with gilts (about 0.7 per cent).
After taking account of these two factors, the excess projected return to project investors is therefore estimated as being about 0.7 per cent. These excess returns are attributed to ‘structural issues’ that in the past have limited compe- tition in the PFI market. For instance, the length of PFI procurements and the level of bid costs incurred by the private sector are thought still to create bar- riers to entry to the market.
We do not disagree with the PwC report as to the significance of a compet- itive PFI market – market capacity and competitive pressures in the bidding process are essential ingredients in generating value for money. But we are also aware that there is a missing piece of the jigsaw, and that is ‘true’ uncer- tainty, and we now consider the possible implications of this distinction for PPP projects.